“Everything is relative in this world, where change alone endures.” – Leon Trotsky

“Many forms of Government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time.” – Winston Churchill

Democracy, according to Freedom House, peaked in 2005. Between the years 1970 and 2005 democracy flourished greatly. As recently as 1973, countries such as Spain, Portugal and Greece were dictatorships, and only forty-five out of the world’s then 151 countries were counted as free democracies by Freedom House. Driven by massive social change at a global level, the number of free democracies had grown to 120 nations by the end of the twentieth century.

Over the last decade, however, democratic institutions have experienced a significant decline. And 2017 saw this trend accelerate. The reversal in fortunes of democracy has emboldened the likes of China and Russia to push for increasing acceptance of the ideologies underpinning their respective brands of governance across the developing world.

The Trump Administration’s inward looking policies and hostility towards pluralist international agreements have opened the door for China to replace the United States as the key power broker in Asia and the developing world. Take, for example, Trump’s decision to withdraw the US from the Trans-Pacific Partnership (TPP), which was followed up by Xi Jinping’s rousing support for globalisation at Davos in January 2017 and again at the Belt and Road Forum in Beijing in May 2017. And it is not just bravado; China is pushing for greater integration amongst Asian economies by driving negotiations for the Regional Comprehensive Economic Partnership (RCEP) – a proposed 16-nation free trade agreement that includes the ten member states of the Association of Southeast Asian Nations (ASEAN) and Australia, China, India, Japan, South Korea and New Zealand.

Chinese efforts to wrestle away US influence in Asia are not limited to the RCEP alone.

In May 2014, Xi called for an “Asia for Asians” – a security concept encouraging Asian nations to step up and assume leadership in administering regional order. Xi’s words were provocative at the time but are progressively coming to reflect the emerging reality in Asia.

The China-Pakistan Economic Corridor (CPEC) – a collection of infrastructure projects under development across Pakistan valued at USD 62 billion – is a formalised strategic alliance that will connect landlocked parts of China to the port of Gwadar on the Arabian Sea and gives China substantial influence over Pakistan.

China has also deepened ties with countries, such as the Maldives, Sri Lanka and Nepal, that have traditionally fallen in India’s sphere of influence. Leveraging its position as the Maldives’ biggest debt holder, China has entered into a free trade agreement with the Maldives in November last year and also received the government’s endorsement for its “Maritime Silk Road” plan. Sri Lanka too has capitulated under the burden of Chinese debt and has handed over the strategic port of Hambantota to China on a 99-year lease. Chinese firms also control a container terminal in Sri Lanka’s capital Colombo. In Nepal the Left Alliance, a pro-China and communist party, propelled by China’s pledge to invest over USD 8 billion in developing Nepal’s infrastructure won the recent elections by a landslide and will take power in March 2018.

China’s deepening ties within Asia, while true to Xi’s “Asia for Asians” mantra, form part of its much larger vision: the Belt and Road Initiative. The Belt and Road Initiative, at times dubbed the Chinese Marshall Plan, is an ambitious economic policy centred on international infrastructure development. It will span four continents and encompasses the construction of two broad networks:

– The “Silk Road Economic Belt” a land based transportation network combined with industrial corridors along the path of the Old Silk Road that linked China to Europe; and

– The “Maritime Silk Road” a network of new ports and trade routes to develop three ocean-based “blue economic passages” which will connect Asia with Africa, Oceania and Europe

Scepticism, when the Belt and Road Initiative was unveiled by Xi Jinping in October 2013, ran high. For all its ambition, the fact remains that there are few countries that trust China. The US retreat and the promise of new infrastructure, however, have seen bottlenecks and political roadblocks fall by the wayside and the initiative has started to gather momentum. Quoting from Caterpillar Inc.’s fourth quarter earnings call (emphasis ours):

“Lastly, we expect to see continued growth in Asia Pacific, led by China. Our forecast is for China to remain strong through the first half of the year, and then slow in the second half, which reflects normal seasonality. In addition to China, we expect most other countries in Asia Pacific to grow, largely driven by investments in infrastructure.”

Equipment manufacturers such as Caterpillar are seeing increased demand out of China and the Asia Pacific. Excavators and loaders, such as those produced by Caterpillar, are amongst the most commonly used earthmoving equipment at construction sites. The increase in orders for such equipment from China and the Asia Pacific are tell-tale signs that the Belt and Road Initiative is underway.

While sceptics will remain and there will be many hurdles along the way, the importance of the Belt and Road Initiative to China cannot be overstated. It is seen as being so important by Chinese leadership that during the Communist Party of China’s 19th National Congress, the following statement was deemed to be a necessary addition to the Chinese constitution:

“Following the principle of achieving shared growth through discussion and collaboration, and pursuing the Belt and Road Initiative.”

Some have speculated that because the Belt and Road Initiative is inseparably connected to Xi Jinping, the inclusion of the above statement into the constitution is a means by which Xi will extend his leadership beyond his term. We, however, think that this objective was already achieved by the enshrining of “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era” into the constitution. The Belt and Road Initiative is China’s path to rebalancing its economy, creating ripe markets for its “Made in China” policy to be a success, and moving up the manufacturing value chain.

China’s expanding influence in Asia comes at the cost of increasing insecurity amongst Japan, India, and the US. The Trump Administration, while being irreverent towards globalisation, contains amongst its ranks deep-seated China sceptics – Director of the White House National Trade Council Peter Navarro and Trade Representative Robert Lighthizer chief amongst them – we think it is unlikely that the US will forfeit its position within the global order without a fight.

India, wary of the Chinese-Pakistani alliance, too, is trying to up the ante. Indian Prime Minister Narendra Modi has signalled a USD 250 billion revamp of India’s armed forces by 2025 and 2017 saw India entering into new defence deals with Israel, Russia and the US. At the same time, India is trying to shore up relations with its neighbouring countries. It extended USD 4.5 billion in project financing to Bangladesh to support infrastructure development, committed USD 500 million in investment for the Chabahar Port in Iran, and also entered into an estimated USD 2 billion agreement with Iran for cooperation in the rail sector.

While China is unlikely to win over western democracies, Japan or India anytime soon, the overtures of Chinese money-fuelled infrastructure projects are likely to prove too tempting for most developing nations. And this, we think, is the reason the Belt and Road Initiative should continue gathering momentum.

Investment Perspective

Equity markets globally have started 2018 with a bang. This year’s most eye-catching market action, in our opinion, however, occurred on 2 January at the Karachi Stock Exchange in Pakistan. Why? Well, for starters, Trump’s first tweet of the year:

“The United States has foolishly given Pakistan more than 33 billion dollars in aid over the last 15 years, and they have given us nothing but lies & deceit, thinking of our leaders as fools. They give safe haven to the terrorists we hunt in Afghanistan, with little help. No more!” – @realDonaldTrump

Given that Pakistan was to receive over USD 255 million and USD 900 million in security assistance from the US for 2016 and 2017, respectively, the freezing of these disbursements subsequent to the US President’s tweet was bad news for Pakistan. Yet the Pakistani stock market went up and has continued to go up since.

Karachi Stock Exchange 100 Index

Source: Bloomberg

Two days after President Trump’s tweet against Pakistan, China unveiled that its second overseas military base would be built in Pakistan. The base will be built at Jiwani, a port close to the Iranian border on the Gulf of Oman and will be a joint naval and air facility for Chinese forces.

China’s growing influence in Asia is real. The Belt and Road Initiative is gathering momentum. The investment implications of these developments may prove to be profound over the next decade. For now, it is a signal that China wants to increase its influence in Asia. Stability is a necessary condition in order to achieve further influence. For this reason, as we noted in Our Thoughts On and Investment Ideas for 2018, China bears stand to be disappointed in 2018.

An added corollary is that one should not be shorting the stocks of construction equipment providers.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“Nobody wants a prediction that the future will be more or less like the present, even if that is, statistically speaking, an excellent prediction.” – Nathan Myhrvold, formerly Chief Technology Officer at Microsoft

“It requires a very unusual mind to undertake the analysis of the obvious” – Alfred North Whitehead, English mathematician and philosopher

The start of a new year is as a good time as any to take stock of one’s portfolio and by extension the investment views underpinning it. Having undertaken the exercise internally, we take this opportunity and share some of our thoughts and investment ideas for the year ahead.

The ideas we present here are amongst our top convictions based on a 6 to 12 month investment horizon. As ever, we remain flexible and should circumstances and / or the data change our investment views too may change.

Japan continues to outperform

We issued a piece on Japan last month, where we argued that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle. This view is predicated on the fact that Japan is already at the forefront of the robotics revolution and has a demographic profile that makes it uniquely sheltered from the potentially negative socio-economic consequences of the increased proliferation of artificial intelligence. Moreover, Japanese companies are flush with cash – cash holdings of companies listed on the Tokyo Stock Exchange are now more than 140 per cent of Japan’s GDP – that they can use to invest in robotics and automation.

Long iShares MSCI Japan ETF ($EWJ).

A bull market in uranium

“The key to the ‘capital cycle’ approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side.”

When it comes to uranium sector, plenty have cried wolf over the years as the commodity’s price crashed following the Fukushima Daiichi nuclear disaster in March 2011. When prices fell below the cash cost of the marginal producer, many felt the bottom was close. Instead, prices continued falling and even dropped below the cash cost of the most efficient producer.

Uranium 308 Physical Spot PriceSource: Bloomberg

Uranium miners cut capital expenditures in response to the decline in price. Some producers even went as far as buying from the spot market to fulfil their deliveries as it became cheaper to buy in the market than to produce. Despite the struggles, supply cuts were few and far between – given tepid demand, the lack of capacity curtailment became a major impediment to any improvement in prices. That is, until recently. In January, 2017, KazAtomProm, the national operator of Kazakhstan for import and export of uranium, announced plans to cut production by 10 per cent – representing approximately 3 per cent of global uranium production. Spot prices rallied in response to the announcement but faded due to slow implementation of the cuts while demand also remained tepid. This past November, Cameco Corporation ($CCJ) – the world’s largest publicly listed uranium company – announced that it would suspend production at two of its mines, representing approximately 9 per cent of total global production, for ten months by end of January, 2018. Less than a month later, Kazakhstan announced that it would cut 20% of its production for the next three years. These announcements sparked a yearend rally in uranium prices.

Our analysis suggests that the announced production cuts, without any improvement in demand dynamics, are sufficient to bring the uranium market into balance over the course of the next 18 months. If demand picks up, however, the market could quickly fall into a deficit, which would push prices up to much higher levels.

Long Global X Uranium ETF ($URA).

US inflation, wage growth and velocity of money all pickup

Historically, periods of labour market tightness when businesses are facing difficulty in filling job openings have preceded increasing wage growth. Comparing the US Small Business Job Openings Hard to Fill index to US wage growth lagged by one year, we find this to be the case up until the end of 2012. Since 2013, however, the relationship appears to no longer hold true. The number of businesses reporting job opportunities difficult to fill has been increasing while wage growth has remained largely absent.

Small Business Job Openings Hard to Fill vs. Wage Growth (Lagged One Year)

Sources: Bureau of Labor Statistics, National Federation of Independent Business

This discrepancy is largely due to headline figures masking the underlying trend. The outsized impact of a handful of industries distorted the average. Based on the data from the Bureau of Labor Statistics (BLS) wage growth has been positive across a majority of industries from 2014 through 2016. The oil and gas extraction industry, unsurprising given the collapse in the price of oil in 2014, has been a major drag on overall wage growth.

“Workers in metro areas with the lowest unemployment are experiencing among the strongest wage growth in the country. The labor market in places like Minneapolis, Denver and Fort Myers, Fla., where unemployment rates stand near or even below 3%, has now tightened to a point where businesses are raising pay to attract employees, often from competitors.”

Rising wages in the US will have disproportionately higher impact on the disposable incomes of low and lower-middle class households. As poorer households’ disposable income increases, they are more likely to increase consumption as opposed to increasing savings, especially when compared to upper and upper-middle class households. Moreover, the spending patterns of poorer households are starkly different to those of richer households – for one they are more value conscious. Retailers and quick service restaurants catering to lower and lower-middle income households are likely to be amongst the greatest beneficiaries of higher wages.

The inevitable corollary is the rising wages will place increasing pressure on businesses to improve productivity. This coupled with the incentives within the new US tax bill for increasing capital spending – cutting the corporate tax rate from 35 to 21 per cent and a capital expensing provision – we expect capital expenditures in the US to pick up during 2018.

The combination of increased capital expenditures and higher wages means corporate cash piles will start turning away from financial engineering and toward investment. Flows out of Wall Street and into Main Street should translate into velocity of money picking up ergo higher inflation.

In our last post of 2017, we outlined our bullish view on industrial commodities. To summarise, on the demand side we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China which, given the Chinese Communist Party’s goal to make housing more affordable and transform rural residents into urban residents, should remain strong over the course of the year. The second is US capital investment, which we expect to pick up in 2018 given the incentives for capital investment created by the new tax bill. On the supply side, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results of these reforms thus far have been largely positive. Given the supply and demand dynamics, we are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

Long Vale SA ($VALE) and United States Steel Corporation ($X).

Emerging markets: Oil exporters outperform oil importers

The sharp drop in oil prices in late 2014 has been a welcome windfall for oil importing emerging markets. Money that was previously being used to pay for oil imports has gone into productive investments as well as increasing consumption. Since the number of oil importing nations far outstrips the number of oil exporting nations, the drop in oil prices has supported the synchronised global economic recovery that we are enjoying today.

As the old saying goes, “Low prices, cure low prices”, the synchronised pickup in global economic activity caused in part by lower oil prices is resulting in demand for oil exceeding expectations. At the same time Russia and OPEC are maintaining high levels of production discipline. Moreover, our analysis suggests that the likes of Mark Papa and Harold Hamm are correct in calling out the Energy Information Administration (EIA) for its optimistic projections for shale production. We think that shale production will disappoint leading to higher oil prices in 2018.

Higher oil prices should lead to oil exporting emerging markets outperforming at the expense of oil importing emerging markets.

At a human level, the pace of adoption of robotics and artificial intelligence, while being cognizant of the possibilities for human advancement, concerns us. We worry that the blind, unchecked development of artificial intelligence could one day tear through the social fabric that binds us together and spread the venom of protectionism across the globe. The business case for artificial intelligence adoption, however, is very strong. A performance gap between early adopters of the technology and laggards will become increasingly evident over the coming years. A widening of this gap is likely to result in an adopt-or-die type of scenario for the laggards. And may even lead to a “winner-takes-all” type of environment where even second-best is not good enough to survive. Companies have no choice but to invest in robotics and artificial intelligence.

Our advice: learn a foreign language. If you have children, encourage them to learn a foreign language too. While Google and others may develop tools to reduce the friction of translation, one can never truly understand a culture without understanding its language. In a world where nations are becoming increasingly inward looking, we need to increase our cross-cultural understanding and there will be, in our opinion, great reward for those that can facilitate such understanding. Learning a foreign language is the first and most critical step in this process.

Long ROBO Global Robotics and Automation Index ETF ($ROBO).

The first trillion dollar company

While this may not materialise in 2018, we think before this bull market is done we will have witnessed the world’s first publicly listed trillion dollar company. It could be one of tech giants – such as Apple, Amazon or Google – or it could be the successful listing of Saudi Aramco. Either way, we think a trillion dollar company will ring the bell at the market top.

China bears disappointed

After the botched currency devaluation efforts of 2015 and 2016, the Chinese government has deftly managed its economy by balancing between fiscal stimulus, risk management within the financial system, and supply-side reforms on the industrial side. While there have been hiccups, such as the gas supply crunch witnessed late last year, the economy has continued to grow smoothly. We expect 2018 to be not too dissimilar with the Chinese government continuing to strike a balance between using the stick and offering the carrot. We expect China bears to have little to celebrate in 2018.

Onslaught of cyber-attacks

In 2017, cybercrime came of age:

US-based consumer credit reporting agency, Equifax, suffered a massive data breach compromising the data of over 143 million of its customers

WannaCry a ransomware was unleashed in May 2017 and targeted computers running Microsoft Windows by encrypting data and demanding ransom payments in the Bitcoin cryptocurrency

NotPetya ransomware attack forced shipping giant Maersk to halt operations at 76 port terminals around the world, which translated into an estimated financial cost of USD 300 million

Television network HBO was hacked in late July. A group of hackers claimed to have stolen roughly 1.5 terabytes of information from the company, including scripts and episodes of popular TV show Game of Thrones

The above are but a few examples of the cyber-attacks that took place in 2017. In an increasingly hyper connected world, we expect the scale and frequency of cyber-attacks will only increase.

Long Cyber Security ETF ($HACK)

Household consumer stocks underperform

We wrote about avoiding household consumer names in October last year – namely constituents of the Consumer Staples Select Sector SPDR ETF ($XLP). We maintain this view for 2018 as we consider their valuations to be stretched for businesses that are increasingly susceptible to disruption and shifting consumer preferences towards more niche brands.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“We must not forget that housing is for living in, not for speculation. With this in mind, we will move faster to put in place a housing system that ensures supply through multiple sources, provides housing support through multiple channels, and encourages both housing purchase and renting. This will make us better placed to meet the housing needs of all of our people.”

“Let the market, not politicians, determine the flow of rice, oil and other commodities. Lower, more stable prices will ensue.” – Steve Hanke, Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise

“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.” – Karl Marx

Industrial metals have had a great run starting in late 2015 and early 2016; equities of industrial metal producers even more so. Given this rally and the uncertainties around the Chinese investment-led growth model, one of the more difficult investment questions we have struggled with is: whether this bull market in industrial metals is sustainable or not? Our analysis seems to suggest that it is.

Commodity Research Bureau (CRB) US Spot Raw Industrial Index

Source: Commodity Research Bureau

We have a fairly straightforward framework to help us develop our initial opinion on the outlook for industrial metals. The framework is centred on Chinese money supply metrics, both M1 and M2, and essentially functions as a heuristic for capital spending in China. Chinese capital spending, as is widely accepted, has been the primary driver of demand for industrial commodities over the last two decades.

As a part of this framework we monitor the dynamic between two measures of money supply, M1 and M2. As M1 is a more narrowly defined measure of money supply consisting of the most liquid components – such as physical cash, checking accounts and demand deposits – of overall money supply, any increase in M1 relative to M2 is indicative of a move away from saving and toward investment. For example, companies that hoard cash tend to hold it in the form of time deposits and other financial assets, should the need to make capital investments arise, they would have to unwind these financial investments. This unwinding of financial investments into cash results in M1 increasing while M2 remains unchanged. To monitor this dynamic we simply calculate the ratio of M1 to M2. A higher number means M1 is increasing relative to M2 while a low number means M1 is declining relative to M2.

The ratio of M1 to M2 has been increasing since the end of 2015, indicating a higher propensity to invest than to save in China.

Ratio of China Money Supply M1 to China Money Supply M2

Source: The People’s Bank of China

While this ratio is informative during periods the ratio is trending, either upwards or downwards, it adds little value during periods it is stable, as witnessed between 1999 and 2007. In such periods, we rely, instead, on the year-on-year growth in M1. If M1 to M2 ratio is stable, then a growing M1 is indicative of an increase in the absolute level of investment in the economy. As a rule of thumb, growth in China’s M1 has tended to manifest itself in higher industrial commodity prices 4 to 8 months down the line.

Chinese M1 increased rapidly between the end of 2015 and early 2017 but has started to decline since. So while this signals a decline in the rate of growth in investment, the metric remains positive. This combined with a higher propensity to invest over saving, as indicated by the M1 to M2 ratio, suggests that the level of investment in China should remain healthy during the first half of 2018 and support continued demand for industrial commodities.

This framework has worked well as a timing tool for investing in industrial metals since the turn of the century. It may continue to work well, we suspect, as long as Chinese demand is the primary determinant of commodity prices. The limitation, however, is that the framework is purely Chinese demand centric and does not take into consideration substantial demand creation or destruction from other parts of the world; nor does it give weight to changing supply-side dynamics.

On the demand side, we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China, ergo housing demand. While the second is the incentives within US tax bill for corporations to increase capital investment in the near term.

Xi Jinping in his speech at the Communist Party of China’s 19th National Congress addressed the need to “put in place a housing system that ensures supply through multiple sources”. To our mind this is as much to do with affordability as it is to do with the supply of housing, which is why Xi specifically mentioned encouraging renting as part of the solution.

Earlier in the year, the Chinese government announced that it will allow, on a trial basis, the development of rental housing projects on rural land – the trial will be conducted in 13 cities including Shanghai, Beijing, Guangzhou and Shenzhen. According to data from Centaline Property, 10 cities have already allocated land for rental housing construction. Chief amongst them is Beijing, where authorities expect to supply 6,000 hectares of land for residential housing by 2021, almost a third of which will be for rental housing. Beijing has even gone as far as announcing a new rental housing policy, which guarantees the same education rights to the children of the tenants of rental properties as the rights afforded to the children of property owner. The new policy even enables tenants renting government-subsidized housing to have their household registration (“hukou”) on their rented homes.

The Chinese government’s objective is to make housing more affordable. House prices in major cities have become exorbitantly high and this is a factor contributing to the dampening in the rate of Chinese urbanisation. If the government’s goal of transforming the Chinese economy into a consumption-led, as opposed to investment-led, economy is to be achieved, urbanisation needs to continue unabated for many more years. Simply because urban consumers clearly outspend rural consumers – after all, the Joneses do not live in rural China.

Despite the willingness shown by some of the large private sector developers at the early stage – it is not too difficult to nudge companies dependent on government largesse – the challenge for the government will be to create a system in which property developers are able to offload inventory to recoup their investment shortly after delivery, as opposed to collecting rents over many years. Solutions to this problem can involve mobilising capital from pension funds and other institutional investors into rental properties, developing capital market infrastructure to increase the number of real estate investment vehicles such as real estate investment trusts or other forms of securitisation, or simply facilitating increased investment by international real estate income funds into China.

Notwithstanding the challenges, the key point for us is that the Chinese government has a goal that ultimately creates an additional source of demand for housing and thus construction. This incremental demand can only be bullish for the demand for industrial metals.

The incentives for US capital investment created by the potential tax reform maybe somewhat more subtle than the overtures of the Chinese government but might ultimately prove to be as bullish, if not more, for industrial commodities. The key provisions in the tax bill in this regard are the:

Corporate income tax rate being cut from 35 per cent to 21 per cent, effective 1 January, 2018

Capital expensing provision that permits businesses to completely write-off, or expense, the entire value of investments in plant and equipment for five years. Starting the sixth year, this provision is gradually eliminated over a five year period

Cutting the corporate tax rate from 35 to 21 per cent is bound to increase investment into the US. On top of that, the capital expensing provision within the proposal incentivises both new capital that comes into the US as well as existing capital to be put into plant and equipment. At a time where companies are struggling to recruit adequately trained staff and productivity growth is non-existent, the capital expense provision is likely to result in a substantial increase in the demand for capital goods — and for industrial commodities.

Coming to supply, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results thus far have been largely positive.

Investment Perspective

Deflationary forces reward businesses that delay investment and maintain low levels of inventory. The lack of capital investment and the absence of excess levels of inventory, in turn reduces the risk of impairment, write-down or liquidation. Without write-downs or liquidation, the business cycle continues, albeit unimpressively. This has been the case since the Global Financial Crisis and especially after commodities peaked in 2011/12.

What if given the supply and demand dynamics, however, we are at the early stages of an industrial commodities bull market? What if the depleted inventory levels combined with reduced production capacities leads to a feeding frenzy whereby rising prices result in rising demand? The latter is the very dynamic witnessed in the semiconductors market this year. And we certainly see it is a plausible, albeit low probability, scenario for industrial metals for 2018.

We are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

We are long Vale SA ($VALE) and United States Steel Corporation ($X). We will be looking to add other names and direct commodity plays on any meaningful pullbacks.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“The aging and decreasing population is a serious problem in many developed countries today. In Japan’s case, these demographic changes are taking place at a more rapid pace than any other country has ever experienced.” – Toshihiko Fukui, the 29th Governor of the Bank of Japan

“I have experienced failure as a politician and for that very reason, I am ready to give everything for Japan.” – Shinzo Abe

“Here is the reality of Japan’s demographic crisis: at eight births per 1,000 people, Japan’s birthrate in 2013 was among the lowest in the world. Meanwhile, the proportion of the population over 65 is now 25%, the highest in the world. In 2010, Japan’s population peaked at 128 million. Current projections show the population dropping below 100 million by 2048 and as low as 61 million by 2085. The country’s working-age population has been declining since the late 1990s, making it increasingly difficult to care for Japan’s retirees.” – Saskawa Peace Foundation USA

Japanese stocks are breaking out (have broken out?). Irrespective of which measure of market performance you prefer, the TOPIX or the Nikkei, the recent performance of Japanese stocks has been impressive. And, if you are wondering, it is not because of a weakening yen.

Tokyo Stock Price Index (TOPIX)

Source: Bloomberg

Nikkei 225 Index

Source: Bloomberg

Japan’s demographic challenge is well-documented. More than a quarter of the population are 65 years old or older. Birth rates are at record lows. And since one of the market truths many of us have come to know and accept is that “demography is destiny”, we know that Japan’s economy will only continue to struggle. With the prevalence of this type of thinking, it is no surprise that many have been confounded by the recent rally in Japanese stocks.

Channelling our inner Charlie Munger we inverted and asked ourselves: under what scenario would Japanese-style demographics be the precursor to an economic boom? In our attempts to answer this question we have to come to the conclusion that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle because of demographics not in spite of them.

We arrived at this conclusion due to one simple reason, we think that the Japanese economy is well-placed to lead and reap the benefits of the coming robotics revolution. Concurrently, Japan’s demographic challenge means, while the country is not entirely immune, it is uniquely sheltered from the potentially negative socio-economic consequences that may arise from the increased proliferation of robotics and artificial intelligence. (We have previously articulated some of our concerns around the unbridled development of artificial intelligence in Artificial Intelligence and Meaningful Work.)

Unemployment is low. Labour force participation levels are high. The overall population is declining while the elderly population is increasing and the labour force dwindling. Corporates are hoarding cash – companies listed on the Tokyo Stock Exchange just set a new record –their cash holdings are now more than 140 per cent of Japan’s GDP. The enormity of the level of cash holdings is better appreciated when compared to the 43 per cent of US GDP equivalent held in cash by US corporations – this 43 per cent includes the much talked about cash held offshore by the likes of Apple and Microsoft.

Japanese Unemployment Rate (%)

Source: Bloomberg

Japanese Labour Participation Rate (%)

Source: Ministry of Internal Affairs and Communications

The confluence of all these factors makes Japan ripe for the uptake of robotics to really accelerate but for one missing ingredient: capital investment. Although there is some evidence of capital investment picking up, Japanese companies have continued to demonstrate high levels of restraint when it comes to capital spending.

Despite the investment restraint shown by corporations, necessity, invention and a focused robotics strategy introduced by the government in 2015 – New Robot Strategy – has already positioned Japan at the forefront of the robotics revolution. We think there are a number of factors that will push Japanese corporations towards increasing capital investment and lead them to aggressively adopting robotics and artificial intelligence.

During the campaigning for the recent elections, opposition leader Yuriko Koike – governor of Tokyo and former Minister of Defense – called for a punitive tax on corporate cash reserves in order to encourage companies to invest more. While Koike’s new Party of Hope was resoundingly thumped by Prime Minster Abe’s Liberal Democratic Party (LDP), Koike’s criticism of corporate cash hoards resonated with members of the LDP. The government of Japan, we expect, will exert increasing amounts of pressure on companies to force them into spending their cash piles by increasing capital investment and paying higher wages.

When President Trump came into office he promised to shake up global trade in order to put America first and cut the US trade deficit. He brought in global trade hawks – Secretary of Commerce Wilbur Ross, Director of the White House National Trade Council Peter Navarro, and Trade Representative Robert Lighthizer – to form part of his administration. To date, very little of note has been achieved by the Trump administration on the trade front. With Trump also having failed to deliver on the domestic policy front, however, we think he will seek to overcompensate by taking a more aggressive stance on US trade policies. Especially as the president has the power to levy trade tariffs on countries without needing approval from Congress. More importantly for Japan, however, we think the Trump administration is also likely to become more aggressive in calling out countries they deem to be “currency manipulators”. And with the yen significantly undervalued in terms of its real effective exchange rate, there is little room for the Bank of Japan to talk down the yen. Moving forward, Japanese companies are unlikely to be able to rely on an undervalued currency to drive exports. Quality and sophistication – two traits that have traditionally been the hallmarks of Japanese products – will have to come to the fore. And that requires capital investment and potentially re-shoring of some manufacturing capabilities back to Japan.

The Chinese government’s strategic plans are progressively more focused on increasing local consumption and having much more of its population employed in higher-paid positions. This requires Chinese businesses to move up the value chain. And it is in response to such government objectives that industrial companies in China have started to move into the production of higher-value added goods – venturing into territories normally occupied by Japanese companies. As the threat from China intensifies, Japanese industrials will have to respond by increasing the complexity and quality gap between them and the competition. The Japanese, however, do not have the luxury to call upon a deep pool of labour. They instead will have to invest in robotics and automation if they are to have a chance of staving off the Chinese threat.

Given all the above factors, we think it is not a question of if but when Japanese companies will start increasing capital investment. And we think that the time has come.

Japanese Industrial Production vs. the Unemployment RateSources: Ministry of Economy Trade and Industry, Bloomberg

Investment Perspective

Corporate profits as a share of GDP, in Japan, are making new highs. Higher profits combined with high levels of cash and low levels of leverage encourage companies to undertake capital expenditures. Capital expenditures increase private sector profits and create demand for credit to the benefit of banks. Et voilà, a virtuous economic cycle.

Japan Credit to Private Non-Financials (% of GDP) vs. TOPIX Index

Sources: Bank for International Settlements, Bloomberg

While not so simple, Japan indeed is on the cusp of a virtuous private sector profit cycle. So the question to our minds is not whether one should have an allocation to Japan or not but rather should the allocation be currency hedged or not. And to do that we say, ignore those calling for the yen to 200 and do not hedge. On a real effective exchange rate basis, the yen is significantly undervalued.

Japanese Yen Real Effective Exchange Rate

Source: Bank for International Settlements

While this is a broad market call, we do want to highlight two sectors – one to overweight and the other to avoid. One of the sectors we are most bullish on in Japan is the healthcare equipment and services sector comprising of companies such as Olympus Corporation and Terumo Corporation. Japan is at the forefront of elderly patient care – its population has the longest average lifespan in the world. Healthcare equipment and services providers in Japan have supported the Japanese healthcare sector in facing the challenges posed by a rapidly aging population by delivering cutting edge solutions. As the US and Europe increasingly face up to the demographic challenges Japan has already gone through, there is an inevitable opportunity for Japanese healthcare equipment and service providers to increase their global reach and grow their exports to the US and Europe.

The one sector that we prefer to avoid in Japan is the financial sector. If a capital investment cycle kicks-off in Japan, as we expect it to, Japanese companies do not need to borrow – they are already sitting on so much cash – and this perhaps means that this spending will not automatically lead to an increase in demand for credit and nor does it imply that a meaningful rise in interest rates will be forthcoming.

We are long the iShares MSCI Japan ETF ($EWJ) as well as a select number of healthcare equipment and services providers.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“One of the most robust findings in the economics of happiness is that unemployment is highly damaging for people’s wellbeing. We find that this is true around the world.”

…

“Not only are the unemployed generally unhappier than those in work, but we also find that people generally do not adapt over time to becoming unemployed unlike their responses to many other shocks.”

Excerpts from “Happiness at work”, CentrePiece magazine, Autumn 2017, London School of Economics and Political Science

“Participating in the satisfying work of innovating enriches lives by endowing them with purpose, dignity, and the sheer joy of making progress in challenging endeavors. Imaginative problem-solving is part of human nature. Participating in it is essential to the good life – and no elite minority should have a monopoly on that.”

…

“The technologies our species is developing might either hold the keys to unlocking human potential — or to locking it up more tightly than ever.”

“Viewed narrowly, there seem to be almost as many definitions of intelligence as there were experts asked to define it.” – “Abilities Are Forms of Developing Expertise”, Robert J. Stenberg, Educational Researcher, April, 1998

“One day the AIs are going to look back on us the same way we look at fossil skeletons on the plains of Africa. An upright ape living in dust with crude language and tools, all set for extinction.” – Ex Machina (2014)

In Matilda, the children’s fantasy movie directed by Danny DeVito and based on Roald Dahl’s book of the same name, the lead character, six-and-a-half year old Matilda, on her first day of school correctly calculates the result of 13 times 379 in her head – much to the amazement of her teacher and classmates. If such an event had taken place in our classrooms, we too would have been astounded and many, if not all, of us would have described young Matilda as being intelligent or even a genius. Yet if we told you that we have a machine that can solve the very same problem in less than a nanosecond, would any of you describe it as being intelligent? We suspect not; although, some may describe the person who designed the machine as being intelligent.

What then is intelligence?

We conducted an informal experiment (read: an impromptu poll on Whatsapp) involving our school friends. We asked our friends a simple question: who was the most intelligent person in our year group at school? The experiment covered three different schools from three different cities. Without exception, the choice was unanimous for each school.

After collecting their responses, we asked each of our friends a follow-up question: what is intelligence? Some gave us the Oxford Dictionary definition, others referenced IQ or some other standardised test scores while others still bifurcated intelligence into ‘book smarts’ and ‘street smarts’. Each person’s interpretation of what intelligence is was somewhat unique. Despite that, each person came to the same conclusion of who the most intelligent person at school was.

Exploring some of the academic research available on the understanding of intelligence, we found that opinion of what intelligence is was just as, if not more, divided amongst academics and researchers.

While we, collectively as a race, may not have a unified understanding of what intelligence is this has not impeded our shared progress. We, however, do not have the luxury of not understanding artificial intelligence, its possible evolution from here on out and what it means for the future of employment.

Millions of blue-collar manufacturing jobs have already been automated away by machines. This was the low hanging fruit for artificial intelligence. It has been widely accepted for well over a decade that technology would gradually replace workers in process-oriented roles where the objectives are well defined and the operating environment is controlled. The development of artificial intelligence, however, now threatens to automate away non-routine jobs across a vast number of industries. PricewaterhouseCoopers has predicted that 38 per cent of American jobs could be automated by 2030. They identify jobs in industries such as human health and social work, financial & insurance, education, mining & quarrying and public administration & defence as those with high level of susceptibility to automation. McKinsey Global Institute is even more apocalyptic as it estimates that as many as 800 million workers worldwide may lose their jobs to robots and automation by the year 2030.

A survey of history reveals that many new technologies have been sub-optimally utilised for years, sometimes even decades, before a more effective use of the technology has been discovered. If artificial intelligence is being sub-optimally utilised, it may not be the case for long. In May this year, Google unveiled its AutoML project, which is based on the concept of an artificial algorithm becoming the architect of another artificial intelligence algorithm without the need for a human engineer. Facebook has also started incorporating AutoML into parts of its architecture while Microsoft invited teams to compete in an AutoML implementation competition.

Why does AutoML matter?

Until now, engineers and developers have used trial and error to choose the best algorithm or set of algorithms to solve problems. After model selection engineers are also heavily engaged in the iterative process of optimising the algorithm and its parameters to the specific problem at hand. This entire process is resource intensive. It requires hundreds, if not thousands, of man hours and mind-boggling levels of computing power. As a consequence, costs of solving a single problem can run into the millions of dollars.

AutoML, on the other hand, automates the entire process of model selection and optimisation; saving computational capacity by not having to optimise and re-optimise models; and significantly reducing development time from weeks and months to days. AutoML capabilities will only grow over time and the complexity of problems it is able to solve is also likely to increase.

The progress of AutoML has been rapid. Take the case of AlphaGo, the Go playing artificial intelligence developed by Google’s DeepMind, which defeated the world’s number one human Go player. AlphaGo was a technological marvel with 48 artificial intelligence processors and data from thousands of Go matches built into it. It was no match for AutoML, however. DeepMind developed AlphaGo Zero an algorithm that was only given the rules of Go and then proceeded to teach itself and create an algorithm to play Go – all without any additional human input. AlphaGo Zero defeated Alpha Go at its own game only 40 days later. In fact, during a period of 72 hours, AlphaGo Zero beat the original by a margin of 100 to 0. What is even more startling is that the AlphaGo Zero only utilises 4 artificial intelligence processors – a 12 fold improvement over AlphaGo in terms of processing power requirement.

If the example of AlphaGo Zero is a peek into the future of non-routine, dynamic capabilities of artificial intelligence then the role of humans in the workplace is at risk of being marginalised to oversight and system refinement.

Adoption of artificial intelligence outside the technology sector remains limited. Few companies have deployed it at scale. However, the business case for artificial intelligence adoption is strong. A performance gap between early adopters of the technology and laggards will become increasingly evident over the coming years. A widening of this gap is likely to result in an adopt-or-die type of scenario for the laggards. And may even lead to a “winner-takes-all” type of environment where even second-best is not good enough to survive.

As adoption increases, the implications for the human workforce are likely to be far reaching. To quote Wired: “The AI threat isn’t Skynet. It’s the end of the middle class.” The threat of artificial intelligence is seen as being so grave that many have toyed with the idea of a universal basic income – a guaranteed living wage paid by government – as a possible solution should artificial intelligence result in widespread job losses for the middle class. But what of human dignity and the meaning we find at work in solving problems and in collaborating with our colleagues? And what of our right to pursue happiness if we can no longer fulfil our ambitions and aspirations but rather live from one government hand-out to the next?

Investment Perspective

“We are subject to the processes and trials of evolution, to the struggle for existence and the survival of the fittest to survive. If some of us seem to escape the strife or the trials it is because our group protects us; but that group itself must meet the tests of survival.

So the first biological lesson of history is that life is competition. Competition is not only the life of trade, it is the trade of life – peaceful when food abounds, violent when the mouths outrun the food.” – The Lessons of History (1968), by Will and Ariel Durant

Away from capital markets, the personal investment implications of the development in artificial intelligence are far reaching. While we can be accused of being pessimistic, we do not want to be ignorant to the challenges artificial intelligence poses. We understand and acknowledge not only the benefits the technology could deliver to businesses but also in solving problems humans have struggled with for decades and centuries. Artificial intelligence may one day help us overcome cancer or develop early warning systems for natural disasters – such possibilities excite us. The blind, unchecked development of artificial intelligence, on the other hand, scares us as it could one day tear through the social fabric that binds us together and spread the venom of protectionism across the globe.

For those of us with children, we have many difficult decisions to make and challenges to overcome in helping our children prepare for the world that awaits them. In our humble opinion, the risk-reward for teaching and learning foreign languages is skewed to the upside. While Google and others may develop tools to reduce the friction of translation, one can never truly understand a culture without understanding its language. In a world where nations are becoming increasingly inward looking, we need to increase our cross-cultural understanding and there will be, in our opinion, great reward for those that can facilitate such understanding. Learning a foreign language is the first and most critical step in this process.

We encourage all of you to learn and to encourage your children to learn at least one foreign language.

On the capital markets side, we reiterate our earlier call that we are at the beginning of a long-term secular trend towards automation and recommend positioning in a basket of automation and robotics related companies through the ROBO Global Robotics and Automation Index ETF ($ROBO).

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Chandler: No, honey you’re not sick! Look, I don’t love you because you’re organised, I love you in spite of that.

Monica: Really? You promise you won’t tell anyone?

Chandler: Yes! And look, now that I know if I got some extra stuff lying around can we, can we share the closet.

Monica: Well…it’s just umm…I’m afraid you might mess it up.

– “The One with the Secret Closet” – Season 8, Episode 14, Friends

“I’ve learned that for hoarders, every cleanup is a grieving process. We are asking them to say goodbye to items that are heavy with memories – some wonderful, some painful. But all are important and deserve respect. A hoarder finds safety in the hoard, in the stacks and piles, and he or she will grieve over the loss of those items when they are gone. The week after the house cleaning is usually the worst. Instead of being happy and enjoying the new space, hoarders go through a difficult process. They miss their possessions, which were their closest friends for years.” – Matt Paxton, The Secret Lives of Hoarders: True Stories of Tackling Extreme Clutter

“Everything is bigger in Texas, loaded double barrel blow you to pieces” – Texas Bloody Money by Upon a Burning Body

If everything is bigger in Texas, can we say it’s even bigger-er in China?

Held on every eleventh of November, Singles Day is the busiest day of shopping in the Chinese calendar. It is a day to celebrate singlehood – the anti-Valentine’s day so to speak – that has become synonymous with Alibaba, the Chinese e-commerce conglomerate that, starting 2009, turned the day into the Chinese equivalent of Black Friday. The day has turned into a retail phenomenon, so much so that in recent years more revenue has been generated on Singles Day than on both Black Friday and Cyber Monday combined.

Alibaba goes to great lengths to grab consumer attention ahead of the Singles Day event. City streets and subways across the Mainland are plastered with advertisements about its 11 November promotions. The sales during Singles Day have become a critical barometer of the health of the Chinese consumer and of Alibaba’s dominance in the Chinese e-commerce market.

The kick-off to the holiday shopping season in US is no different to the days leading up to Singles Day in China. Each holiday season starts with an intense barrage of advertisements about promotions and bargains on offer. Stores start to open earlier and stay open for longer. All these efforts are in attempt to get the consumer to spend more. Holiday shopping is a challenging time for all consumers but is an especially difficult time of the year for hoarders – compulsive shoppers that are most susceptible to fall prey to guerrilla marketing tactics.

Although research shows that only between 2 to 5 per cent of the population meets the criteria to be clinically classified as a hoarder, there is an almost universal tendency to over accumulate. And it is this tendency that has underpinned the long-running building boom in self-storage capacity across the US.

Self-storage is a segment of the commercial real estate market concerned with the provision of space for the storage of possessions. Self-storage space, in the US, has unique economic and legal characteristics including requirements such as month-to-month basis rentals; the tenant having exclusive access to their unit; and a no bailments clause on facility operators with respect to the goods stored by tenants.

The first modern self-storage facilities opened in Odessa, Texas, during the 1960’s. The industry maintained a low-profile for almost two decades, largely functioning as a pit stop for the possessions of those in transition. The rising wealth of the baby boomers, however, changed all that. Come the 80’s and 90’s, these storage facilities were increasingly occupied by old furniture and other unwanted household items. This trend has continued unabated and has even accelerated since 2001. A study by the Self Storage Association found that by 2007 more than half of self-storage clients in the US were storing stuff that did not fit in their homes – remarkable, considering the size of the average American house almost doubled over the last five decades.

The proclivity of the average person to procrastinate, especially when it comes to disposing of unwanted possessions, has underpinned the resilience of the self-storage industry. So much so, that occupancy rates in the US only declined by around 2 to 3 per cent in the immediate aftermath of the Global Financial Crisis. Occupancy levels also recovered quickly as rising foreclosures and people’s inclination to downsize their homes created an added need for storage space.

The rise of e-commerce has spurred new demand for self-storage space. It is cheaper and more flexible as compared to renting space in commercial warehouses – making it ideally suited to online retailers and Amazon Store operators who need flexible solutions to manage inventory. Even brick and mortar retailers in metropolitan areas, looking to reduce their footprint and rental costs, are turning to self-storage facilities to store their goods offsite. These trends combined with the sector’s resilience to downturns in the economy may warrant the somewhat boring and often overlooked self-storage sector having an allocation in one’s investment portfolio.

Investment Perspective

Over the decades, self-storage has evolved from being a fringe component of the commercial real asset class to a core asset within the real estate industry. Capital flowed into the industry as it has proven its ability to deliver above average yields while showing resilience in times of uncertainty. Despite the resilience of the sector and its improving financial performance during 2016, the Bloomberg REIT public / self-storage sub-index is down around 17% from its peak in 2016.

Bloomberg REIT Public / Self-Storage Sub-IndexSource: Bloomberg

Approximately one in ten American households already pays for a personal storage unit. This mass proliferation of self-storage has occurred during a period when new homes purchased by Americans have on average been larger than their previous homes. The trend of bigger homes, however, is reversing. The American citizenry is now building and buying homes with smaller square footage than in previous decades. While at the same time self-storage facilities are at around 90 per cent occupancy and a growing number of cities – New York, San Francisco and Miami to name but a few – have moved to restrict or curb the development of new self-storage facilities. In our opinion, a confluence of all these factors combined with the added demand from e-commerce and brick and mortar retailers may lead to a shortage in space and allow storage operators to raise prices. In turn the earnings profile of storage operators should improve and lead to a re-rating in the self-storage REITs.

We are long CubeSmart ($CUBE), Extra Space Storage ($EXR) and Life Storage ($LSI) and a complementary play we are also long AMERCO ($UHAL).

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“Here’s something to think about: How come you never see a headline like ‘Psychic Wins Lottery’?” – Jay Leno

“Nothing in life is as important as you think it is when you are thinking about it.” – Thinking, Fast and Slow, Daniel Kahneman

“I hate to lose more than I love to win.” – Jimmy Connors

Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979, is a descriptive model that characterises how people choose between different options and how they estimate the perceived likelihood of each of these options. The main findings of Prospect Theory are:

People care about gains or losses more than about overall wealth;

People exhibit loss aversion and can be risk seeking when facing the possibility of loss; and

People overweight low-probability events.

The Chicago Board Options Exchange Volatility Index, better known as the VIX, is the primary gauge used by equity and options traders to monitor the anxiety level of market participants. The VIX measures the market’s expectation of 30-day volatility of the S&P 500 index. The higher VIX is, the higher the anxiety levels amongst market participants.

Market participants can express their view on short-term market volatility through a number of instruments. Two of the most common ways used are selling options on an equity index or by shorting the VIX. As equities tend to decline as volatility rises, the preference amongst market participants is to sell puts over selling calls. Added to that, puts are usually more expensive than calls; selling puts generates a higher premium.

Selling volatility, using either equity index options or by shorting the VIX, is the capital markets equivalent to selling lottery tickets. Large losses in a strategy involving selling volatility tend to coincide with market crashes. Large but rare losses, i.e. negative skewness, justify a positive risk premium for the strategy.

Selling volatility on equity indices has provided attractive payoffs over long periods of time. The strategy had a high long-run Sharpe ratio over the two decades between the 1987 crash and the 2008 Global Financial Crisis. Even higher levels of performance have been achieved by the strategy since the equity market lows in 2009. The reason the strategy has been profitable is largely due to implied volatilityon equity indices consistently trading at a premium over realised volatility. Based on monthly data from 2005 till date, as shown in the chart below, the average differential between the implied and realised volatility on the S&P 500 index is 1.2%.

S&P 500 Index Implied Volatility less Realised Volatility

Source: Bloomberg

Selling volatility has become a very popular trade, to say the least. The proliferation of exchange traded funds (ETFs) and exchanged traded notes (ETNs) that track either the performance or the inverse of the performance of the VIX has made selling or buying volatility, otherwise complicated trades to structure, accessible for the average investor. Investors can go long the inverse VIX instruments or short the long VIX products if they want to sell volatility.

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are under weighting as opposed to over weighting a low probability event (a market crash). At the same time, they are giving preference to negative skewness, favouring small gains at the risk of incurring large losses.

During October, 2017, the VIX recorded its lowest monthly average since the launch of the index dating back to January, 1993. What makes this statistic even more remarkable is that autumn months are generally more volatile with October being, on average, the most volatile month during the year. The average level of the VIX for October, starting 1993, is 21.8 – more than double the 10.1 averaged last month.

Proshares Short VIX Short Term Futures ETF Price PerformanceSource: Bloomberg

With volatility recording all-times lows and equity markets at all-time highs, some have called selling volatility the “most dangerous trade in the world” while others expect an inevitable rise in volatility to cause a significant correction in US equity markets. While these views may prove to be correct, our view is slightly more nuanced.

The increased availability of volatility instruments has made trading volatility more liquid than it used to be. Just as other securities benefit from a re-rating as their liquidity improves, volatility has structurally re-priced due to the proliferation of vehicles facilitating short and long volatility trades. We do not know the degree to which this increased liquidity should improve valuation but accept that volatility should be lower than it used to be prior to this structural shift.

Another reason why we think volatility should be structurally lower today than it used to be is the rise of passive investing. Passive investment vehicles are gathering an increasing share of assets and deploying them in systematic manner. A systematic allocation strategy is by construct more predictable, less volatile than a discretionary allocation strategy.

Taleb, in his paper “Bleed or Blowup? Why Do We Prefer Asymmetric Payoffs?” featured in the Journal of Behavioral Finance in 2004, argues that the growth of institutional fund management also contributes to the rise in the negative skewness bias. We consider the case for money managers preferring investment strategies exhibiting negative skewness to be credible as such strategies superficially boost Sharpe ratio over extended periods of time, supporting asset gathering efforts.

With all that being said, we do consider the short volatility trade to be richly valued. That does not mean we expect the equity market to crash, instead the differential between implied and realised volatility has tightened to such a degree that this gap can easily close and invert. The trade can become loss making without a meaningful correction in equity markets.

Investment Perspective

The S&P 500 index’s implied volatility is almost two standard deviations below its average over the last 7 years. Not being psychics and being cognisant of the incremental improvements in the economy, we are not calling for a significant correction in the overall market. However, such low levels of volatility, in our opinion, are bound to lead to investor complacency in areas of the market that do not warrant it. And it is these areas of the market we search for to avoid or short. While at the same time we also search for areas where anxiety levels are extended and have the potential to revert back towards the mean.

S&P 500 Index Historical Implied VolatilitySource: Bloomberg

In our search we have found two sectors where we find unwarranted levels of complacency: airlines and cable & satellite and broadcasting businesses.

Capacities are rising in the airline sector at a time where costs are also rising. Airlines have enjoyed a significant tailwind due to the crash in oil prices; however, oil prices are rising and we expect further upside to oil prices from here. This will be a major headwind for airlines at a time when there are already cost pressures from rising salaries for pilots due to a shortage of qualified pilots. Despite the headwinds, implied volatility for airlines stocks are at one to two standard deviations below their averages.

Southwest Airlines Historical Implied Volatility

Source: Bloomberg

American Airlines Historical Implied Volatility Source: Bloomberg

Delta Airlines Historical Implied VolatilitySource: Bloomberg

Cable & satellite and broadcasting businesses face structural issues that bring into question the viability of their business models. These issues are similar to the challenges faced by advertising agencies that we have articulated in Unbranded: The Risk in Household Consumer Names. Despite the challenging outlook, we find investor complacency to be high in a number of names within the sector.

CBS Historical Implied VolatilitySource: Bloomberg

We consider the shorting of stocks in the sectors with challenging prospects combined with high levels of investor complacency, as a means to selectively reduce short volatility exposure or to go long volatility without the time decay or negative carry of direct long volatility trades.

To complement our short ideas, we have also identified one area of the market where we find high levels of anxiety after significant draw downs have already taken place: the general merchandising sector. While there is still potential for further pain in the overall retail sector, we find there is an opportunity to pick up the pieces in a segment where we find some value.

Target Historical Implied VolatilitySource: Bloomberg

Dollar General Historical Implied VolatilitySource: Bloomberg

Dollar Tree Historical Implied VolatilitySource: Bloomberg

We are long target ($TGT), Dollar General ($DG) and Dollar Tree ($DLTR) and are short Southwest Airlines ($LUV), American Airlines ($AAL), Delta Airlines ($DAL) and CBS ($CBS).

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.